David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Equifax Inc. (NYSE:EFX) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Equifax Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Equifax had US$2.87b of debt, an increase on US$2.63b, over one year. However, because it has a cash reserve of US$135.8m, its net debt is less, at about US$2.73b.
How Healthy Is Equifax’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Equifax had liabilities of US$1.50b due within 12 months and liabilities of US$3.39b due beyond that. Offsetting these obligations, it had cash of US$135.8m as well as receivables valued at US$502.6m due within 12 months. So its liabilities total US$4.25b more than the combination of its cash and short-term receivables.
Equifax has a very large market capitalization of US$16.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Equifax’s debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Even worse, Equifax saw its EBIT tank 39% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Equifax’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Equifax produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Equifax’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. We think that Equifax’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. While Equifax didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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